Andrew Crockett: Progress towards Greater International Financial Stability

Speech by Andrew Crockett, the General Manager of the Bank for International Settlements, at the 'Reforming the Architecture of Global Economic Institutions', End-of-Programme Conference of the GEI Programme, London 5 May 2000.

1. Introduction

The decade of the 1990s saw a series of international financial crises on a scale and frequency unprecedented in the post-war period. The economic costs were high, spill-over effects were widespread, and the political and social consequences were severe. Not surprisingly, calls for the reform of the international financial architecture mounted.

In the past two years there have been a plethora of international conferences devoted to this general theme. To those who expected them to result in a new "system", comparable in its coherence and comprehensiveness to the Bretton Woods arrangements, the outcome of these deliberations is no doubt a disappointment.

But this would be to set the wrong standard. There is no brand new "system" waiting to be discovered. What has been achieved, (inter alia through programmes such as the one sponsored by the ESRC), however, is a better understanding of the strengths and weaknesses of current arrangements. From this flows an agenda of incremental reforms that, if carefully pursued, should result in a stronger and more efficient international monetary system.

There is no realistic alternative to an economic system based on decentralised market forces. This has been virtually universally accepted at the national level since the collapse of centrally-planned economic systems more than a decade ago. And it applies equally at the international level. When governments attempt to control decisions about the allocation of real resources, they typically introduce rigidities and inefficiencies that outweigh any benefits stemming from the pursuit of social objectives in economic decisions.

But this does not mean that markets can be left to themselves, either nationally or internationally. Economics teaches us that free markets allocate resources efficiently only under conditions of perfect competition, and these rarely apply in their most rigorous form. Public policy therefore has to deal with circumstances of market failure.

Some forms of market failure have been well understood for a long time. Perhaps the best known is monopoly. Nobody disputes the need for governments to either break up monopolies or to regulate them in the public interest. But there are other types of market failure, particularly common in markets for the intertemporal exchange of value, that have been analysed in depth only more recently. Many of them fall under the general heading of asymmetric information.

Asymmetric information introduces inefficiencies into markets that lead to sub-optimal outcomes, and in some cases to volatility and multiple equilibria. Capital markets are particularly prone to problems of asymmetric information.

This is unfortunate, since financial markets have come to play the central role in the international monetary system. Exchange rates for most currencies are now determined by supply and demand in private markets. Liquidity is created as a by-product of credit granted in private markets. And the adjustment process is largely governed by private capital flows. If capital markets function inefficiently, or are subject to volatility, the consequences are potentially widespread.

All of this has major implications for the architecture of the international monetary system. It means that the rules that govern international financial relations, and the institutions that monitor them, have to be directed towards making capital markets function better, rather than to supplanting private markets with officially-directed flows.

In what follows, I will begin by looking at the recent history of financial crises. This will provide the background against which to analyse the causes and consequences of financial market failures. Next, I will consider how international financial arrangements have evolved over the postwar period and what are the central features of the present architecture. After that I will discuss how the architecture needs to be reformed, both with regard to the "rules of the game" that govern international financial relations, and with regard to the institutional structure for managing monitoring and adapting these rules. Finally, I will have something to say about whether changes are needed in the way we handle the periodic crises that are bound to afflict the system.

2. Recent Financial Crises

Four serious crises occurred in the 1990s that warrant attention for the lessons they convey about vulnerabilities in international financial arrangements. They are the ERM crisis in 1992-93; the Mexican Crisis of 1994-5; the East Asian crisis of 1997-98; and the Russian/LTCM crisis of Autumn 1998. (There were of course a host of other crises of lesser magnitude, or confined to one country.)

2.1 The ERM Crisis

The ERM crisis occurred when market participants lost confidence in the willingness of European countries to maintain currency parities against the D-Mark. Up until the middle of 1992, expectations of a smooth transition to monetary union had given rise to strong stabilising capital flows. These "convergence plays" had caused interest rates spreads to narrow, in effect creating easier monetary conditions in certain countries with pre-existing inflationary pressures. Divergences in economic circumstances, resulting from the reunification of Germany, were largely discounted.

Following the negative result of the Danish referendum on the Maastricht Treaty, doubts about the process of monetary union began to mount. Capital flows tended to be reversed and could be contained only through a renewed widening of spreads. Widened spreads, however, far from demonstrating countries' commitment to stick to their ERM parities, served to cast doubt on the sustainability of the arrangement. In some cases, Italy for example, higher interest rates meant that the cost of servicing the high outstanding debt level rose alarmingly. In others, such as Britain, rising interest rates further intensified the depression in the housing sector, and placed severe strains on mortgage-holders.

Eventually, several ERM member countries, as well as some non-members that had pegged their exchange rate to the DM were forced by massive speculative pressure to either realign or to abandon altogether pegging arrangements. The following year, speculative pressures returned, and resulted in a widening of the exchange rate bands to +/- 15%.

The ERM crisis was an example of what came in the literature to be called a "second-generation" type of exchange rate crisis. That is to say, it was caused not by an unsustainable balance of payments position (France had a comfortable surplus, but was still the victim of massive outflows) but by a perception that the domestic policies required to maintain the exchange rate would ultimately prove unsustainable. The markets were in effect betting that there was a dual equilibrium and that the authorities would be unwilling to pay the price of adhering to their preferred equilibrium and would be forced to accept the second best.

2.2 The Mexican crisis, 1994-95

The Mexican peso crisis that broke out at the end of 1994 had some of the same elements. Mexico had experienced heavy capital flows and upward pressure on its currency for several years until early 1994. External investors had been impressed by the pace of economic liberalisation in the country, and had (too) readily accepted the argument (advanced by Finance Minister Pedro Aspe, and endorsed by a wide spectrum of influential opinion) that because the Government had no significant budget deficit, it was protected against a currency crisis. Not enough attention was paid to the dangers of rapid expansion of bank credit by newly privatised banks, and the very weak supervisory system then in place.

The build-up to the crisis started in early 1994, when a series of political events (a violent uprising in one province, and the assassination of the ruling party's Presidential candidate) caused foreign investors to reduce and subsequently reverse capital inflows to the country. The authorities financed this reversal of confidence by running down reserves and borrowing in foreign currency. Following the change in the Presidency, a modest devaluation was undertaken as a means of strengthening the balance of payments.

The devaluation was clumsily handled and led to a collapse in the currency. The value of the Peso more than halved, and its slide was only halted by a co-ordinated support package of some $50 billion. This was another case of multiple equilibrium. A small change in the exchange rate did not restore confidence, because the short-term effect on the balance sheet of the government and financial institutions, both of which were heavily exposed in dollars, far outweighed the longer-run effect on competitiveness. Moreover, uncertainties about how much and how rapidly devaluation would be passed through in higher inflation cast doubt on the sustainability of almost any exchange rate. Such doubts also attached to the currencies of other countries in Latin America, which as a result faced markedly higher financing costs in international markets (the "tequila" effect).

2.3 The East Asian Crisis, 1997-98

Damaging though the Mexican crisis was, the East Asian crisis that started in Thailand in 1997 had even greater and more widespread consequences. In one sense, the crisis was a surprise. The growth rates of most of the countries that were affected had been spectacular. Moreover growth seemed to be solidly underpinned by high rates of domestic saving and investment, low inflation and reasonably prudent fiscal policies.

Once again, volatile capital flows played a role, both in the build up to the crisis and in triggering it. And once again, an excessive expansion of bank credit and inadequate prudential standards sowed the seeds of future trouble. Foreign investors (especially foreign banks), impressed by the economic performance of these countries, lent uncritically amounts that, with hindsight, were greater than the countries' absorptive capacities. Balance of payments deficits rose, and a substantial part of investment went into "conspicuous construction". The easy availability of funds and rising property prices dulled financial institutions' critical instincts. Add the cosy expectation that the government-private sector nexus would protect both lenders and borrowers, and the environment was created for massive misallocation of investment resources.

In Thailand, as in Mexico, the government tried to deal with what appeared to be a modest overvaluation of the currency by a modest devaluation. Once again the result was a spiral in which devaluation weakened the position of financial institutions and the weakening of the financial sector led to a further loss of confidence in the currency.

An ingredient that was much more virulent than in the Mexican case was contagion. The crisis spread in the ensuing six months to almost every country in east Asia, including some, such as Indonesia and Korea, that were thought to have sound macro-economic fundamentals. The situation was eventually stabilised with the help of massive loan packages co-ordinated by the IMF. But stabilisation did not come quickly, nor without initial depreciations in currencies that were far beyond any estimates of what was needed to restore mediumterm competitiveness.

2.4 Russia/LTCM, 1998

The last crisis of the 1990s that I want to consider is that which began with the Russian devaluation and unilateral debt moratorium in August 1998. This triggered the turbulence in financial markets in industrial countries that led to the near-collapse of the hedge fund Long Term Capital Management (LTCM). The Russian crisis was the clearest example, though not the only one, of the power of moral hazard. It is hard to believe that the substantial flows of funds to Russia in the two years preceding its default were not at least partly induced by an expectation that Western countries were in some sense committed to the support of Russia. That expectation disappeared with the Russian default in late-summer 1998.

What happened then was a clear example of contagion. The Russian economy in 1998 was small in size (smaller than that of the Netherlands) and had modest trade links with other countries. Moreover, no significant financial institution was materially endangered as a result of its exposure to Russia.

However, Russia's unilateral declaration of a debt moratorium created a pervasive increase in perceived uncertainty. The result was a flight both to quality and liquidity. The desire for quality led to a widening in spreads on lower-grade credits, while the flight to liquidity meant that high quality but less liquid assets also lost value.

This had profound implications for all highly leveraged institutions who managed their portfolios on the basis of the continuous availability of liquidity. LTCM would have been unable to unwind its portfolio without incurring massive losses. Moreover, the prospect of the unwinding would have led to serious losses for other players. In the event, the danger was averted by timely reductions in interest rates and an officially-encouraged rescue of LTCM by its principal creditors. Nevertheless, it had been a close call. It was hardly comforting for the resilience of the international financial system.

3. Lessons of the Crises

It is now time to draw together what can be learned from these episodes and consider what they demonstrate about weaknesses in the international financial system. How are they related to the present "architecture"? To anticipate the argument, I will suggest that, while the roots of each crisis lay in domestic policy mistakes, all of them were triggered and intensified by the greater freedom of capital flows. Open capital markets, in turn, are the key element of an international financial architecture based on decentralised decision-taking.

I will group the symptoms of shortcomings in the present arrangements under four headings. These symptoms are, as will be apparent, interrelated. First comes volatility in international capital flows. Second, unsustainable exchange rate regimes. Third, chronic weaknesses in national financial systems. And fourth, contagion across national boundaries.

3.1 Volatility of Capital Flows

All of the episodes of crisis listed above have seen excess volatility in international capital flows. Periods of optimism have led to substantial inflows. These inflows have not simply been used to finance longer-term direct investment. A substantial part of them have been in financial form, intended to take advantage of interest differentials, or rising equity prices, or in some cases the possibility of currency appreciation. Larger inflows presented difficult problems of absorption for the receiving countries. Sometimes they added to domestic liquidity, pushing up demand and generating inflationary pressures. In such circumstances, asset prices often rose dramatically. An associated development was to stimulate imports and weaken export competitiveness. And by increasing the availability of funds to the domestic financial system, incentives for prudent financial intermediation were dulled.

The problems of excessive inflows are, however, small in comparison to those that occur when the flows are reversed. Central banks find their reserves depleted and are often unable to borrow. Devaluation or floating worsens inflationary pressures and exposes the weaknesses in the balance sheet of the financial system. A currency crisis and a domestic banking crisis interact with one another in a downward spiral. No satisfactory mechanisms exist to halt the process through a lender of last resort or a temporary interruption in the freedom of investors to withdraw funds.

Some indication of the volatility of flows can be gained from Table 1, which shows flows of funds to selected Asian countries before, during and after the recent crisis. The 1996/97 swing in flows to these countries represented about 11% of their current GDP (and about one fifth in the case of Thailand), or one third of their total import payments. Inevitably a swing of such magnitude, even if partly replaced by official balance of payments assistance, provoked a massive contraction of domestic demand.

Table 1: Capital flows in Asian countries
	1996	1997	1998	1999
	in billions of US dollars
	Net private capital flows
Indonesia	11.5	-9.2	-9.9	-8.3
Korea	24.9	-21.2	-21.2	7.1
Malaysia	7.9	1.4	0.8	-8.8
Thailand	16.6	-14.1	-16.1	-6.8
Crisis-hit Asia	60.9	-43.1	-46.4	-16.8
	Net official capital flows
Indonesia	0.6	8.9	7.9	6.6
Korea	-0.4	17.5	11.6	-9.1
Malaysia	-0.8	-0.5	0.4	1.0
Thailand	0.3	7.2	3.5	0.3
Crisis-hit Asia	-0.3	33.2	23.4	-1.2
	Swing in private flows as a percentage of imports
Indonesia	13.9	-49.6	-2.7	6.7
Korea	4.9	-31.9	0.0	23.6
Malaysia	1.1	-8.2	-1.1	-14.7
Thailand	-3.2	-48.8	-4.6	18.4
Crisis-hit Asia	3.4	-31.7	-1.5	11.4
	Swing in private flows as a percentage of GDP
Indonesia	2.6	-9.6	-0.8	1.1
Korea	1.4	-9.7	0.0	6.9
Malaysia	0.8	-6.7	-0.9	-12.5
Thailand	-1.2	-20.6	-1.8	7.5
Crisis-hit Asia	1.1	-11.1	-0.6	3.9
Note: Capital flows are calculated as the difference between the current account and the changes in reserves; private flows are calculated as a residual from an estimate of official flows.

3.2 Unsustainable Exchange Rate Regimes

Another common feature of recent crises has been unsustainable exchange rate regimes. Despite the abandonment of the Bretton Woods system in 1973, many countries maintained some form of fixed-but-adjustable exchange rate peg in much of the period since then. The justification was that stable exchange rates remove an element of uncertainty from private sector decision-making, provide a better environment for macro-economic policy formulation, and protect external competitiveness.

All these considerations have importance. On the other side, however, is the fact that some mechanism has to exist for balancing the supply and demand for currencies over time. In a system where the demand for and supply of foreign exchange is simply the counterpart of current account transactions, the authorities can afford to meet short-run imbalances through changes in reserves, deciding only later whether to respond to longer-lasting imbalances through an exchange rate adjustment or by changes in domestic demand.

By now, however, short-run changes in foreign exchange supply and demand are dominated by capital transactions. Any possibility that an exchange rate will adjust, creates a profit opportunity that market participants are bound to try to exploit. A fixed but adjustable exchange rate regime is liable to become unstable, unless a credible mechanism exists to ensure that the necessary domestic measures to preserve the parity will always be undertaken.

Another problem with fixed but adjustable exchange rates is the lack of an "exit strategy". As soon as a question mark arises over the balance of payments, the country will face a dilemma. To devalue at the first hint of difficulty undermines the rationale for having a fixed rate in the first place. But once a country has begun to resist downward pressures on the rate, there will be political and economic objections to yielding. Virtually every country that devalued or abandoned a fixed rate in the 1990s did so only after a costly resistance and at considerable reputational cost.

3.3 Weaknesses in Financial Systems

Weaknesses in national financial systems have imposed severe costs on the countries concerned. They have also been an element propagating financial difficulties across national boundaries, for two reasons. First, with free movement of capital, the international financial system can be thought of as the aggregation of all the participating national financial systems. Second, domestic financial weakness can act as a constraint on national authorities' ability to pursue needed adjustment policies.

A typical way to dampen pressure on a domestic currency is to raise interest rates. This provides an incentive to holders of the currency not to sell, and it restrains domestic demand, thus strengthening the underlying balance of payments. But if the authorities are concerned about the fragility of domestic financial institutions, they may be unwilling to raise rates. Even if they are willing, market participants will know there is a limit to how far they can go. Devaluation may not be a much more palatable option. If the domestic banking system is exposed in foreign currency, it may be unable to withstand a devaluation. As we have seen, this dilemma was faced in acute form in Thailand.

3.4 Contagion

Lastly, the present international financial system has shown itself particularly prone to contagion. On each occasion when a crisis has affected one country, it has quickly spread to other countries or markets. The ERM crisis began in the associated Scandinavian countries, led to a devaluation of the lira, and shortly afterwards toppled sterling and other currencies. The after-effects were still being felt almost a year later when the French franc came under attack, despite having relatively strong fundamentals.

Similarly in the case of Mexico, a number of other Latin American countries felt pressures and were forced to intervene and/or raise interest rates. This despite the fact that they had virtually no trade and investment links with Mexico. In East Asia, the crisis that began in Thailand spread throughout the region and had echoes as far away as South Africa, the Czech republic and South America. And as we have seen, the Russian default had severe repercussions on the New York money markets.

Contagion seems to exist for real, financial and purely psychological reasons. Ironically, the least important cause seems to be real trade linkages. It is true that when one country is forced to devalue, the competitive position of its trading partners (especially in third markets) will be adversely affected. But this does not seem to have been a major factor in the spread of recent crises. More important has been financial contagion. Lenders to countries that have got into difficulties have often used risk management models that mechanically require them to sell assets in the same asset class ("proxy hedging"). Psychological contagion occurs when problems in one country serve as a "wake-up call" to investors to reassess their exposure in countries with similar non-financial characteristics.

Regardless of how contagion gets started it can be rational for investors to take it into account in their behaviour. If the withdrawal of funds by an "irrational" investor reduces the likelihood that a "rational" investor will be repaid, then the rational investor will have an incentive to withdraw early. This phenomenon is familiar from the literature on bank runs. It is usually used as the justification for having a lender of last resort, to prevent a liquidity crisis turning into a solvency crisis. Because national banking systems have a lender of last resort, bank runs hardly ever get started. In the international financial system, however, there is no comparable mechanism to guard against currency runs.

Financial contagion, like physical disease, tends to affect first those that are most vulnerable. So it is true that in most recent episodes, countries affected by contagion have usually had certain inherent weaknesses. This was true in the ERM crisis, and it was true in the Asian crisis. Countries with stronger fundamentals, such as France in the ERM and Hong Kong, Singapore and Taiwan in Asia, generally survived the crisis with less cost. This does not detract from the point, however, that the difficulties created by contagion were disproportionate to the underlying economic weaknesses in the countries concerned.

4. The changing financial architecture

The sources of crisis identified above are all, in one way or another, connected to the greater role played by integrated capital markets in the current financial architecture. It is therefore worth pausing to consider how this came to be. How has the architecture evolved over the postwar period? What are its strengths and weaknesses? This will provide a basis for discussing reforms aimed at tackling the weaknesses while preserving the strengths.

The monetary arrangements devised at Brettons Woods gave governments substantial influence over international financial flows, and left relatively little to private markets. It was, in the words of Padoa-Schioppa and Saccomanni¹ a "government-led" international monetary system. A key objective of the system was to liberalise trade flows, and to provide convertibility for current payments. Fixed exchange rates were assumed to facilitate the growth of trade, and any changes in exchange rates had to be multilaterally agreed. If imports and exports were not in balance (net of flows of long-term capital), the difference would be reflected in changes in foreign exchange reserves. Countries were expected to respond to movements in reserves by adjusting macroeconomic policies so as to restore payments equilibrium at the given exchange rate. If necessary, the resources of the IMF (and its policy conditionality) were available to assist the process. In extreme cases of "fundamental disequilibria", an exchange rate adjustment could be undertaken, approved by the IMF.

This system worked reasonably well so long as national capital markets were insulated from one another, and long-term capital flows were of an official nature. But as private capital flows grew in importance they began to play a much greater role in the adjustment process. The growth of the euro-dollar market in the 1960s signalled the beginning of a period in which mobile capital would flow into (and out of) countries based on expectations of relative short-term yields.

The first consequence of this trend was to undermine the regime of fixed-but-adjustable exchange rates. Market participants could see the emergence of unsustainable payments positions, and could form expectations as to whether they would have to be corrected by an exchange rate adjustment. By so doing, of course, they brought forward the need for governments to take action. Reserves could less easily be used to "buy time" to decide on adjustment policies. Either credible action had to be taken at once to demonstrate the sustainability of an exchange rate, or else speculative outflows would soon force a change in parity.

This characteristic of capital markets is to introduce what Jacob Frenkel² has called "the non-linearity of time". Capital markets concentrate at a moment in time the received consequences of past events (the assets and liabilities created by past transactions) and the expected consequences of future developments (the flows of claims implicit in current policies, and the price expectations they engender).

What is the implication of this "non-linearity of time"? Most importantly, it means that it is harder to sustain disequilibria in prices and quantities. If market participants have confidence in the sustainability of the policies of a government or a private borrower, then capital flows will help reinforce the status quo; if not, they will quickly undermine it.

With open capital markets, governments cannot easily manage either exchange rates or the adjustment process or liquidity creation. What they can manage is their domestic macro-economic and structural policies. In the new international financial architecture, it is the markets' perception of these that drives the pattern and volatility of capital flows, and the associated developments in the exchange rates and liquidity.

How should we judge this fundamental change in the international financial architecture? Is it a matter of regret that governments can no longer set exchange rates, limit capital flows and prevent the emergence of the kind of crises we have experienced in recent years? Or should we be glad that resources are now allocated by the market's "hidden hand", even if this leads to periodic spectacular episodes of turbulence?

As in all such questions, the answer is neither one nor the other. As a practical matter, however, there is no turning the clock back to an era where capital flows were of minor importance. The sophistication of our financial infrastructure has simply progressed too far to make it possible, even if it were desirable. Yet it is almost certainly not desirable either. Private capital markets have facilitated an enormous resource transfer to emerging markets. Although not always used wisely, this has contributed materially to faster rates of capital formation and output growth. Capital flows have also encouraged the transfer of technological and managerial know-how. And they can act as a source of discipline on borrowers and the policies of borrowing countries. All this is to the good and should not be lightly compromised.

On the other hand, it cannot be denied that free capital mobility has contributed on occasion to serious resource misallocation and to damaging instability. And a major weakness is that the exercise of discipline on borrowing countries' policies is all too often exerted much too late. So the answer, "leave it to the market", cannot be accepted either.

Instead, I believe the approach has to be one of dealing better with cases in which private markets are inefficient, or lead to instability. The approach to the new architecture, in other words, has to be to focus on helping markets allocate resources effectively, rather than on supplanting market judgements. This is analogous to the role that is increasingly accepted for governments in national economies. In most advanced countries, governments no longer have a major role in enterprise ownership or in price setting. But they do have a growing role in regulating the conditions in which the private sector operates and monitoring how it behaves. And there is a growing, sophisticated literature on how regulation needs to be designed so as to enhance competitive market forces, rather than stifle them.

5. Reform: New Rules?

Against this general background, what can be said that is more specific about the conventions and guidelines that should govern international economic and financial relations? I will discuss that in this section before going on to institutional questions in the next one.

The rules and conventions that I suggest are needed share certain important elements of continuity with the past. Clear support should be given to free trade, and a multilateral approach to the management of the international financial system. But whereas past rules have sought to define the international interface between governments' policies (exchange rates, liquidity provision, adjustment obligations, and so on), the new conventions will have to define domestic requirements relating to the sustainability of structural and macroeconomic policies and, most importantly, the prudent and efficient operation of financial systems. If the job of pursuing sustainable and appropriate domestic policies in these areas is achieved, much of the task of managing international financial flows can be left to private markets. (Not all, however, for there will remain the task of dealing with shocks and breakdowns in the functioning of private markets).

5.1 Macroeconomic policies

Since domestic macro-economic policies are a sovereign responsibility, it might be thought unnecessary, and even inappropriate, to try to devise internationally applicable rules. However, shifts in macroeconomic policies have effects on savings/investment balances, and hence on exchange rates and on international flows of goods and capital. They therefore have an international dimension that justifies an attempt to at least provide some framework or general guidelines. This is not unprecedented. Such a framework is explicitly apparent in the Maastricht treaty, which lays down fiscal deficit and debt limits for participants in monetary union.

There is now little dissent from the proposition that countries should aim at a low and stable rate of inflation (1-3% is probably the range that is most generally favoured³, ⁴). This is widely viewed as being in the national interest as well as being consistent with stable international relations, so is not particularly controversial.

A prudent budgetary policy is likewise widely supported. The Maastricht treaty puts a limit of 3% of GDP on budget deficits and 60% as the upper band of the debt/GDP ratio. Economists have quibbled with the mechanical application of these ratios, (with good grounds), but few have disputed the general objective they embody. So international understandings here too should be relatively easy to reach, without the need for formal agreements.

A more problematic issue is the exchange rate regime. For obvious reasons, countries have wanted to have stability in their exchange rates. It facilitates the formation of monetary policy and it provides a stable environment for the development of export-oriented industries. But as already noted, fixed exchange rates pose particular difficulties in an environment of free capital flows. If markets perceive that domestic economic policies are inconsistent with the chosen exchange rate, they will speculate on a change. If the government resists, but does not change sufficiently its domestic policy priorities, the subsequent adjustment can be abrupt and painful.

As a result of experiences with currency crises, it is now increasingly believed that governments have to pursue one of three courses. First, they can credibly make clear that the domestic economy will be allowed to adjust to take the strain of pressures on the exchange rates. This variant can be referred to as "strong fixing" and can be given institutional strength through a currency board, or the adoption of a currency union. Secondly, they can strengthen administrative restrictions on capital flows. Thirdly, they can allow their currency to float, so that a movement in the exchange rate can absorb the incipient impact of changes in payments flows.

The first option, "strong fixing" is only practicable for a country that has flexible domestic institutions, and a demonstrable will to accept domestic "pain" to preserve the fixed peg. This means that relatively few countries will find this the preferable option. Those that have a history of domestic monetary mismanagement (Argentina, for example) may be able to mobilise political support for strong fixing as a way to escape their hyper-inflation legacy. And countries with highly flexible markets (such as Hong Kong) can also be successful in this strategy.

The second option, capital controls, is also of limited applicability. Controls will be neither desirable nor feasible in the longer-term for countries with developing financial sectors, and they will over time forfeit some of the advantages from integrated capital markets.

This means that the third option, greater flexibility in the exchange rate, is likely to be the preferable option for most countries. It is clearly not without disadvantages, but it is the only one that significantly reduces the potential for currency crises of the type that have plagued the international financial system. It is important to note that exchange rate regimes that are in principle flexible can be supported by policies designed to impart a good deal of stability ex post. But not of course in all circumstances.

5.2 Financial stability policies

The key lesson from the financial crises of the 1990s is the need to strengthen domestic financial systems. Weaknesses in financial systems have been independent sources of instability in many countries, and have compounded the effects of currency crises in others.⁵ Table 2, updated from a recent book by Morris Goldstein⁶, shows the resolution costs of recent banking crises, expressed in relation to the GDP of the country concerned.

Table 2: Cost of Banking Crises 1980-1999

Country (time period of crisis)	Estimate of total losses/costs (percentage of GDP)
Latin America Argentina (1980-82) Chile (1981-83) Venezuela (1994-95) Mexico (1995)	55 41 a 18 12-15 b
Africa Benin (1988-90) Cote d'Ivoire (1988-91) Mauritania (1984-93) Senegal (1988-91) Tanzania (1987-95)	17 25 15 17 10 c
Middle East Israel (1977-83)	30 d
Transition countries Bulgaria (1990s) Hungary (1995)	14 10
Asia Indonesia (1997 - ...) Korea (1997 - ...) Malaysia (1997 - ...) Thailand (1997 - ...)	59 17 10 24
Industrial countries Spain (1977-85) Japan (1990s)	17 10 e

^a 1982-85.
^b accumulated losses to date.
^c in 1987.
^d in 1983.
^e estimate of potential losses.

Sources: Caprio and Klingebiel, (1996). "Bank Insolvencies: Cross-Country Experience". Unpublished. Washington: World Bank.

World Bank, December 1999, "Global Economic Review"

How can the international community set about the task of strengthening national financial systems? This is a large question, and I will try to break it down into manageable components. I will discuss first the coverage of the concept of financial stability, noting that it goes well beyond the, admittedly important, subject of financial sector supervision. Then I will describe the broad approach to improving the stable functioning of the financial sector which is now being pursued through the development of codes of best practice and prudent behaviour. These can serve as a benchmark for regulatory efforts and a standard to which individual countries can aspire to converge. Next, I will say something about how these standards can be developed, monitored and, if necessary, amended. Finally, I will comment on the management of the process - how to ensure that countries have the right kind of incentives to pursue international standards, what to do if progress is inadequate, how to identify gaps in regulations, and vulnerabilities in the system, and so on.

5.2.1 The coverage of financial stability

For the financial system of a country to be stable and efficient, three separable elements have to work well. First, the key institutional intermediaries (banks, securities issuers, insurance companies and fund managers) have to operate efficiently and prudently. Second, the markets in which they transact (equity, fixed income, foreign exchange and commodities) have to be open and transparent. And third, the infrastructure within which financial transactions take place (accounting conventions, contract law, enforcement of property rights, bankruptcy arrangements, corporate governance, payment and settlements arrangements, etc) has to be robust and well understood.

Shortcomings in any one area can undermine the stability of the financial system more broadly. Prudent rules for capital holding by financial institutions are of little use if accounting rules allow bad loans to be concealed. Valuation of financial claims are very difficult if uncertainty surrounds how property rights will be treated in a bankruptcy procedure. Investment decisions become risky when markets are not transparent, and so on. A first step therefore, is to recognise that the new financial architecture requires a large number of bricks to be laid. There is no substitute for painstaking work on a number of fronts if the financial sector of emerging economies is to be brought to a level in which it is resilient to most potential shocks.

5.2.2 The approach to strengthening systems

Recognising that there are multiple aspects to a robust and well-functioning financial system, it is now widely accepted that best practice needs to be defined in each of these aspects, and a strategy developed for its implementation.

Standards need to be global in their application, because the financial industry is global. There is always a risk that financial intermediation will gravitate to centres with weaker standards (regulatory arbitrage) or that disturbances in weaker centres will spill over to other countries (contagion).

As the same time, standards have to be applicable to countries with widely different histories and institutional structures. It would be unreasonable to expect an emerging or developing country with a rudimentary financial sector to comply with standards that an advanced financial centre has reached only after decades of development. Sensitivity will be required to balance the desire to move quickly to best practice, with the need to recognise practical constraints.

5.2.3 How to develop standards

It would be possible to imagine standards being developed and applied by an international financial institution, either the IMF or a new institution created for the purpose. However, the balance of advantage seems to lie in allowing committees of national experts to develop standards in their respective spheres. In the first place, they are closer, in their day-to-day activities, to the practical issues that arise in regulating financial activity. Secondly, once they have debated and agreed an international standard, they are more likely to understand and "buy in" to its practical implications.

There remains an issue of representativeness. Giving all countries a share in the development of standards is at first sight attractive, but it has to be recognised that it is often a recipe for paralysis. On the other hand, attempting to force on the many standards designed by the few will produce resentment at best and active resistance at worst. How can this problem be overcome? One way, which has been found to work reasonably well by the Basel Committee on Banking Supervision, is for the key financial centres to get together to work out rules which they voluntarily agree to abide by themselves. If these rules are well-designed, they will then, through peer pressure and market forces, acquire wider applicability.

Two requirements are necessary for this process to have effectiveness and acceptability. First, there must be a genuine process of consultation, whereby those not directly represented in the standard-setting body can have their views considered in reaching recommendations. Second, recommendations have to be applicable not only to the small group that designs them, but to the broader population of countries that will have to apply them.

It is noteworthy that those standard-setters that reach agreement in small groups (with consultative procedures) such as the Basel Committee, have generally speaking managed to implement standards faster than those that have had more outwardly "democratic" procedures. Moreover, it does not seem as though the Basel Committee's recommendations have had significant difficulty being accepted outside the standard-setting group.

5.2.4 How should standards be implemented?

The question of implementation is key to the success of an approach based on development of codes of best practice. The requirements here are (i) effective prioritisation of standards (there are now 60 plus standards on the Website of the Financial Stability Forum, so some prioritisation is essential); (ii) incentives to encourage the speedy adoption and implementation of codes; (iii) the provision of a mechanism to monitor progress in implementation (and to disseminate the results); and (iv) the provision of resources to help countries identify and deal with shortcomings in their financial systems.

The most effective tool in implementation is the market. When the market rewards high standards of financial regulation with greater market access and lower borrowing costs, there is little doubt that countries will pursue higher standards without the need for outside pressure. To do this, however, it will be necessary to ascertain which standards are of key importance. Countries can make their own "audit" of their systems, and this will undoubtedly be helpful in raising consciousness about underlying weaknesses. However, it seems likely that they will often need expert assistance to identify problem areas, then to remedy them, and finally to attest credibly that standards have indeed been upgraded.

All of this is an appropriate mission for the IMF and the World Bank in the new financial architecture. Indeed, in some sense it could be seen as their key function: equipping national authorities and private markets with the capacity to handle international financial relations in an efficient and stabilising way. The purely financial role of the two institutions would then be to deal with the much smaller range of cases where market failures led either to inefficient outcomes or to financial instability.

5.2.5 The Management of the Process

To recapitulate the argument so far: the new architecture is based on resources allocated by national and international capital markets. A key requirement is the improved functioning of markets, and the removal of sources of market failure. This requires an upgrading of standards across a wide range of areas. A large number of standard setters are involved, as are national authorities and the international financial institutions.

With such a wide range of actors, some coordination is required. The key ministerial level committees are the G7, the G20 and the International Monetary and Financial Committee. These provide the overarching framework for monitoring the architecture.

With regard to the more specific task of identifying potential vulnerabilities in financial systems, and proposing approaches to dealing with them, the recently (1999)-created Financial Stability Forum has a key role to play. I will come to this in the next part of my remarks.

6. Reform: New Institutional Mechanisms

The broad implication of the preceding analysis is that the role of international financial institutions is to deal with market failures in private markets, not to replace private capital flows. This is a considerable change from the focus of these institutions when they were set up. It is not, as I will try to show, a diminution in the importance of their respective roles.

6.1 The International Monetary Fund

The IMF has for a long time been centrally involved in policy advice to its member countries (as an aside, I have always thought it unfortunate that the term "surveillance" has been attached to this activity). The need for policy advice is likely to continue, though the nature of the dialogue changes as national authorities increase their own complement of highly trained economists.

The focus of the Fund's ongoing work (i.e. outside crisis situations) must be to help markets work better, and to avoid the build-up of unsustainable imbalances. One way in which it can do that is by acting as a standard-setter in areas of its expertise (macroeconomic policies). It has already usefully developed standards of data-transparency, and could perform a similar function in the, admittedly more judgmental, areas of fiscal and monetary policy guidelines.

Another important role of the Fund is to help in the dissemination and implementation of standards developed by others. As already pointed out, building a safe and efficient financial system is a complex and time-consuming task. It requires sensitivity to differing institutional structures across countries. Countries will undoubtedly require help to, first, assess the weaknesses in their financial systems; second, develop a strategy for dealing with them; and third, in securing technical assistance to implement the strategy. Finally, it will be important for the Fund to certify that high standards are being maintained on an ongoing basis.

6.2 The World Bank

The World Bank's role will also change. Indeed it has already changed substantially over recent decades. Instead of being the principal source of foreign capital for many developing countries, it is now, in aggregate terms, a relatively minor player.

The role of the Bank can be seen as being to enhance the effectiveness of private flows and to replace them only when they are not adequate or appropriate to particular public policy objectives. There are a number of important ways in which the Bank can improve the effectiveness of capital flows coming through market channels.

First, just as one of the Fund's most important contribution is policy advice, so the Bank's expertise can help developing countries design better overall strategies. Its involvement in such a broad cross-section of countries gives it a unique perspective on how to tailor development strategies to different institutional and economic settings.

Second, it can lend to specific sectors and programmes with important positive externalities (education, health, infrastructure). These are often neglected, especially in countries facing stringent budgetary positives.

Third, it can help upgrade the financial system through which resources are mobilised and allocated. Financial sector weaknesses act as a drag on countries' capacity to mobilise investable resources and allocate them efficiently.

Fourth, it can act as a direct provider of funds when economic and political risks inhibit the private market from playing an adequate role.

6.3 The Bank for International Settlements

Next something should be said about the role of the Bank for International Settlements and more generally of the Basel process. The BIS is a forum for cooperation among all the leading central banks in the world. This cooperation has become more important as the role of central banks in promoting monetary and financial stability has become more prominent. The "Basel Process" refers to a variety of committees and informal contacts that oversee cooperation in a number of different areas.

In the field of monetary and foreign exchange policies, regular meetings among Governors and other senior officials provide the basis for in-depth information sharing. This stops short of policy coordination, but is a necessary basis to ensure that national policies are not inadvertently inconsistent or destabilising. It also provides a kind of "early warning system" to raise consciousness about impending sources of strain in the system.

As far as the financial system is concerned, central banks are looked to in most countries for an overarching responsibility for stability. This includes their role as a lender of last resort, but goes considerably farther than that. The BIS can provide a venue at which the international implications of market developments can be discussed. This enables central banks to share perspectives on changing market structures and dynamics, and to discuss possible responses to sources of tension. This, too, falls short of policy coordination, but is probably necessary to make the "soft law" of codes and standards operationally effective.

6.4 Other Institutional Actors

Looking beyond the central institutions in the International Financial Architecture, a greater role will have to be played by other actors and groupings, such as private sector financial institutions, international standard-setters, and national regulatory authorities. Since the bulk of financial flows are now private, policymakers in the official sector would do well to find imaginative ways to involve the private sector institutions in devising ways to prevent and deal with crises. Standard setters have generally come together as a result of a felt need to impose consistent standards (a "level playing field") across national boundaries. They need to be more directly involved in the debate about how to protect global financial stability more generally. For similar reasons, national supervisors, whose actions affect the international activities of the major regulated financial institutions, should also be drawn into the issue of managing global financial stability.

This brings me back to the role of the Financial Stability Forum (FSF). The Forum was established in early 1999 following a report by Hans Tietmeyer, commissioned by the G7. Underlying the Forum's creation was the recognition that a wide range of national and international authorities now have responsibility for one or another aspect of international financial stability. Yet there existed relatively few mechanisms for information exchange among them, or for consultation on matters of potential systemic vulnerability. The Forum therefore brings together Deputy Finance Ministers, Deputy Central Bank Governors and Heads of Supervision from G7 countries; Central Bank Governors from four additional countries with major financial markets; the heads of the key international standard-setting bodies and senior representatives from the principal international financial institutions. Its mandate is to assess vulnerabilities affecting the international financial system, to identify and oversee action needed to address these vulnerabilities, and to improve co-ordination and information exchange among the authorities responsible for financial stability.

One of the functions of the Forum is to help coordinate the activities of the diverse set of institutions represented in its membership. This should help ensure an overall approach to the design and implementation of standards aimed at enhancing financial stability. The senior level of the Forum's members should help it give impetus to ongoing work in other bodies, whether represented in the FSF or not. And finally, the FSF can work through ministerial-level bodies, such as the G7, G20 and IMFC to help resolve difficult issues.

7. Handling of Financial Crises

However much success is achieved in strengthening financial systems, it would, as I have just said, be unrealistic to expect that financial crises would become a thing of the past. It will still be necessary to have a strategy for when countries get into serious financial difficulty.

Over the past several years, criticism of IMF-supported economic programmes has multiplied. The critics often have diverse reasons for disagreeing with Fund policies, so a clear-cut response is not possible.

One line of criticism is that Fund-supported programmes interfere with the effective working of market mechanisms. According to this line of argument, the Fund is a potent source of moral hazard. If the Fund did not exist, markets would find an appropriate way of disciplining bad policies and imprudent behaviour. The Fund should therefore be abolished. Support for abolition is not widespread, but has attracted support from such influential names as George Schultz and Walter Wriston.

It is hard to believe, however, that the world would be better off with no mechanism to manage crises. It will be impossible to eradicate all sources of market failure and unexpected disturbances will continue to occur. A means is needed to deal with multiple equilibria, to prevent liquidity crises becoming solvency crises, to handle contagion, herd behaviour and the like.

A second line of criticism, reflected in the recently published Meltzer report⁷ is to try to replicate the traditional approach to the Lender of Last Resort in domestic economies. In this approach, the Fund's lending would become less judgmental (or conditional). It would lend more or less unlimited amounts to countries that had pre-qualified through the pursuit of appropriate macroeconomic and financial policies. But in other respects, including its involvement in smaller countries, its role will be curtailed.

Although there are many interesting and useful ideas in the Meltzer report (which I have not done justice to here), it seems likely to be an unduly mechanical approach to dealing with crises. These come in many different forms. It is easy to imagine cases in which additional policy measures, beyond providing finance, are needed to resolve a crisis. It is also easy to imagine situations where outside finance would be useful, and where it is precluded because the country has not pre-qualified.

If the above reasoning is accepted, the Fund's assistance will therefore continue to be needed in a variety of crisis circumstances, even if the number of such crises is reduced in the future. However, the way in which Fund resources are provided, and the size of packages needs careful consideration. Such consideration is of course already under way, but will need to be carried further.

To simplify somewhat, the standard approach to financial programming in the Fund in the past was to estimate an overall balance of payments deficit that needed to be covered by external sources of finance. Measures, largely of a macroeconomic nature, were agreed with a country that would eliminate this overall deficit within a given time frame, say three years. The need for Fund resources was the cumulative balance of payments deficit in the interim.

The liberalisation of capital flows has made this model outdated. The balance of payments "gap" needing official finance is virtually impossible to quantify. If domestic and foreign residents have lost confidence in one or more elements of a country's economic policies (say, its exchange rate commitment or its financial sector's solvency), the volume of capital outflows can be many times greater than the "overall" deficit. On the other hand, if confidence is regained, private short-term flows will relatively easily cover a deficit.

If the amounts of external assistance a country may need to reassure external creditors are hard to calculate, they are also large. Larger, in fact, than creditor countries are willing to provide very frequently, either bilaterally or through the IMF. And even if the amounts were not too large, the consequences of providing finance to, in effect, finance capital flight, raises serious moral hazard issues.

The broad consequences of this analysis are ineluctable, even if the precise implications are not yet clear. The Fund's role in a crisis-hit country cannot be to provide finance to underwrite private claims. This is now widely agreed. Instead, it will typically have three main elements: (i) helping a country design a policy package judged sufficient to restore medium-term viability; (ii) providing financial resources that cover part of the prospective financing need and (iii) helping the country reach understandings with its other creditors to reschedule claims falling due. Exactly how this third element of the Fund's role will be designed is, however, a matter that will take time and ingenuity to specify.

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¹ Padoa-Schioppa, T. and Saccomanni, F. 1994, "Managing a market-led global financial system", in Managing the World Economy: Fifty Years After Bretton Woods, ed. Kenen P. B., Institute for International Economics.

² Jakob Frenkel.

³ Bernanke, B, Laubach, T, Mishkin, F and Posen, A (1999), "Inflation Targeting: Lessons from the International Experience", Princeton University Press.

⁴ Fischer, Stan (1996), "Why are central banks pursuing long-run price stability?", in Federal Reserve Bank of Kansas City, " Achieving Price Stability", Jackson Hole Symposium.

⁵ Kaminsky, G and Reinhart C, 1999, "The twin crises: the causes of banking and balance-of-payment problems", American Economic Review, Vol. 89, No. 3, June, pp. 473-500.

⁶ Morris Goldstein, 1997, "The Case for an International Banking Standard", Institute for International Economics. (Policy Analyses in International Economics, April).

⁷ International Financial Institution Advisory Commission, US Congress (2000): "Report to Congress", March